Month: January 2018

Despite IHS reports of West Texas shale’s economic viability, I am very skeptical of the capacity for additional production out of Texas unless we get higher oil prices, mainly due to the cost of rising land. Land prices now are many multiples what they were a few years ago when oil prices were double today’s levels.

Global demand and a falling dollar have been responsible for an oil rally into the year end. We have synchronized global growth for the first time in two decades, and I think oil demand will continue to grow.

The oil and gas majors have been reluctant to add deepwater capacity, and large capital-intensive projects are being placed on hold as investors become uneasy about the impact of electric vehicles. I think this should add up to a supply shortage over the next couple of years.

The key will be American oil production. Operators are now experimenting with enhanced oil recovery (EOR) in shale, but the techniques are largely untested outside conventional reservoirs. EOR will be a key area to watch, and I am keeping a close eye on the Core Labs earnings conference calls for updates on the industry. There is a possibility that reservoir challenges, like “frac hits”, and challenges with adding additional stages (horizontal drilling has hit upon natural limits to length of wells due to the loss of pressure in the latter stages) will increase the cost of drilling to make marginal shale plays uneconomic.

In addition, the oil operators have benefited from a long period of deflation by the oil service providers – overcapacity in the oil service companies led to falling prices and margins for these companies. As an example, C&J Energy Services, a pure-play on-shore U.S. energy service company, was running razor thin gross margins throughout 2016 (2.5%) and the first few quarters of 2017. However, in the latest quarter, gross margins hit a respectable 23%. I would guess that oil service companies will finally start to price higher in 2018, which will constrain production growth from the E&Ps. Even if you are bullish on American shale, it makes more sense to me to be long the service providers, on the theory that demand will finally allow them to price higher, than the American shale E&P’s themselves, which have production risks.

I am tentatively bullish on non-shale sources of oil. There are some cheap Canadian producers, and, if Trump opens the Pacific to offshore, some of the specialized offshore service companies may be an interesting buy. Computer Modelling Group, for example, has a massive ROIC, and, though it trades at 34X earnings, it’s earnings have been depressed by years of low demand for offshore services.

I think higher oil prices will finally push inflation higher in 2018. Inflation has been subdued for many years. Part of the problem is that, despite falling unemployment, labor force participation has fallen from a pre-crisis 66-67% to, more recently 62-63%. Though the Phillips curve would predict falling unemployment would cause inflation to rise, it does not account for a drop in participation. However, labor force participation has trended higher ever since bottoming out in late 2015 and early 2016. I would also argue that the labor force participation rate is not picking up data about the “gig economy” – Uber drivers, Airbnb renters, etc – which now make up a substantial number of people.

Another component of low inflation has been the low level of consumer spending. However, in recent months, consumer spending has increased, and the personal savings rate declined from 6% to 3% in the past year. There has been an inventory overhang ever since 2015, with the inventory to sales ratio spiking in 2016 to levels not seen in an economic expansion since the late 1990’s. High inventory levels reduce prices across the economy. However, the inventory to sales ratio has declined throughout 2017. For example, after Hurricane Harvey, the auto inventory to sales completely normalized, as the demand for new cars in affected areas sopped up all the excess used car supply on the market. Excess housing inventory has also been nearly completely consumed, causing new home construction to pick up. Millennials are finally moving out of their parents’ houses and forming new households, and this demand ought to drive home construction activity for some time. House prices have finally recovered to long term averages, and the wealth effect on U.S. households ought to contribute to further consumer spending.

The falling inventories and rising home construction have contributed to commodity demand, and since late 2016, nearly all commodities have been on a tear. Capacity reduction in Chinese metals has caused iron ore to recover from a 5-year bear market, and driven a bull market in the metals. Global growth in Southeast Asia, India, and Europe has caused created a perfect backdrop for a roaring commodity bull market.

The U.S. dollar has remained under pressure. One of the most vocal FOMC members, Lael Brainard, was speaking just last year about the necessity for rate hikes, despite weak inflation, to curb rising asset prices. However, her latest speech indicates that she has come around to Ben Bernanke’s argument that a prolonged period under the 2% target rate necessitates a prolonged period over 2% as a “catch up” period. This change in Fed mentality has curved expectations for interest rates downwards. We have limited data thus far on Jerome Powell’s thinking on the matter, but the market consensus is that he is more dovish than Yellen.

On a PPP basis, the dollar is still overvalued versus the euro. Parity remains significantly higher at a EUR/USD level of 1.35. Since the formation of the euro, the dollar-euro pair has touched the PPP level every 2 or 3 years. The dollar rocketed higher in 2014-2015 on the back of monetary policy divergence, however I’d view the dollar’s weakening in 2016-2017 as a correction of this move back towards PPP levels. Higher inflation in the U.S. and lower inflation in the Euro area should continue to drive the PPP towards a stronger euro.

Immediately post-election, I went long the dollar on a thesis that a rising budget deficit and monetary tightening would lead to a strong currency. There are good test cases in the U.S. in the early 1980’s and in Germany in the early 1990’s. In both cases, the currency appreciated wildly beyond levels that would be predicted by PPP. However, I am starting to revise this thesis. Despite increasing rates, I don’t think we can characterize what is currently occurring as a tightening process. We are still in an abnormally loose monetary policy environment. The Taylor rule would predict a “natural rate” of interest at about 4% currently, while the Fed Funds rate is at 1.5%. Excess reserves, as measured by the St. Louis Fed, are still at $2.2 trillion, compared to a nearly zero pre-crisis level. Because banks usually lever at least 10-1, these $2.2 trillion in reserves represent a potentially massive amount of excess liquidity. In an environment where money supply is still relatively large, fiscal expansion should be inflationary and negative for the currency. The Trump administration has passed increases in defense expenditures and a tax cut, which should both cause the deficit to widen next year.

While the Fed’s favorite measure of inflation, PCE ex-food and energy, has still been tracking slightly under 2%, another measure I track, the Dallas Fed’s trimmed mean PCE, has already popped above 2% and now sits at 2.2%. I think the Fed will raise rates next year, but will remain relatively loose because their preferred index remains weak, which ought to allow the dollar to continue to fall and inflation to rise significantly.

Despite prospects for increased inflation in the near future, treasuries have rallied into year end. I know some market participants are taking the view that inflation will remain weak and further rate hikes will invert the curve, cause a recession, and we will see even lower yields on long term bonds. Furthermore, when the curve is flat or inverted, banks cannot make money by borrowing short and lending long. This means with a flat curve, the $2.2 trillion in excess reserves are “impounded” in the banks, and won’t be released into the real economy.

I also think part of the demand for treasuries has come from fund managers seeking protection from a sell-off in equities. Many funds take on leveraged exposure to treasuries, which gives income and has provided a negatively correlated return in times of falling equity prices. This holds true in most environments, except when asset prices fall because of rising inflation. In the 1970’s, the last high inflation era, stocks and bonds had correlated sell-offs due to the pernicious effects of inflation.

However, I have no strong convictions on U.S. equities. I see good arguments for continued easy money and economic growth to push multiples to all-time highs, and economic strength and tax cuts to push earnings higher. At the same time, I get the sense that many of the funds who were holding high cash balances in 2016 and early 2017 are now fully invested, which leads me to question, who will be the marginal buyer at these prices? I have also noted that the latest data out of the BEA shows that foreign capital has moved from inflows (throughout the period of 2009-2016) to outflows this year, which means that any increases in equity prices will have to come from domestic investors. If I am right that equity fund managers are fully allocated to stocks now, the only way we can get excess gains in the stock market is if new liquidity is created by bank lending, or liquidity is transferred from the bond market to equities. I could also see a scenario where we get a sharp correction in stocks because of a drying up of liquidity, but no slowdown in real economic growth, as occurred in 1987.

I would guess large consumer staples companies continue to underperform, as fund managers transition to “growthier” names. In addition, the latest tax reform limits deductibility of interest to 30% of EBITDA, reducing the potential for large 3G-style leveraged buyouts. Finally, with relatively low tax rates to begin with, I think these companies will benefit least from the tax reform. I remain negative on all consumer staples, especially center-aisle food processors, like General Mills and Kellogg. The only risk I see is that a falling dollar boosts international sales. However, I would also argue these companies will have to contend with home-grown competition in these international markets in the near future.

I also am negative on junk bonds. They will likely suffer the most from the reduced deductibility of interest. They will also suffer in a rising inflation environment. I am short the JNK ETF. It recently broke down through the 200-day moving average after the breakup of two major telecom deals, and has not been able to recover above this mark, though it is testing it currently. Coming back to my views on energy earlier, I think that some weakness in the sector in 2018 may worsen the outlook for junk.

Regarding the UK, I am exceedingly negative on the economy. I cannot see a good way out of Brexit. Food prices ought to spike next year, which will continue to place upward pressure on inflation. However, the central bank will be constrained from raising rates due to the pressure it would place on consumers. Wages have not grown as fast as prices, and the majority of UK homeowners have variable rate mortgages, rather than fixed-rate. Any rate hikes will increase mortgage payments and hurt consumer spending, which is already weak.

However, positioning of fund managers is already extremely bearish, especially on UK stocks. There are a number of UK companies that are not correlated to the general economy that should stand to benefit. For example, AA plc looks relatively cheap, and also benefits from the “private equity math”, where paydowns of debt increase the value of the equity. It has a high debt load, stable cash flows, and is entering a new business, insurance underwriting, where it has decades of experience as a broker for 3rd parties. The stock sold off after the previous CEO was abruptly fired for punching a coworker in a barfight, but I think the new CEO is much more stable. Another example is Renishaw, a rapidly growing 3D printing company focused on metal printing, with over 90% of revenues derived from outside the UK. These companies suffer from the general negative UK bias.

I am positive on European equities, particularly heavily levered companies with strong cash flow. A couple of small examples would be Greiffenberger, a German auto parts maker that trades at a 9% FCF yield and has a massive debt load, and Ambra, a Polish wine importer with a much smaller debt load, but also trading at a 9% FCF yield. These companies can benefit from the absurdly low rates in Europe. They also benefit from the sort of “private equity math” I mentioned earlier. The falling dollar has pushed the Euro higher, which gives the ECB an excuse to push out the wind down of QE later and later. All the excess liquidity being added to Europe and suppressing bond yields makes European equities, which trade at markedly lower multiples than in the U.S., relatively attractive. I don’t know what will happen as QE winds down in the latter part of this year, but in the U.S. the rally continued for a significant period of time after QE was reduced to zero.

I am also positive on certain Asian equities. Particularly, I am long Japan and Thailand. I have a theory that Japanese fund managers are investing domestically for the first time in nearly 30 years, which is why the correlation between the yen and Nikkei has broken down. The BOJ’s direct equity purchases essentially make Japanese equities a one-way bet. Japanese fund managers, as recently as summer of 2017, were running massive exposure to U.S. assets, and as they pull money out of the U.S. and invest domestically, it should push the dollar down, the yen up, and stocks higher. This should cause Japanese GDP to pick up, due to the two-way connection between the stock market and real economy. In addition, Japan’s huge advances in fields like robotics and artificial intelligence ought to benefit the economy going forward. I would rather own Japanese stocks in yen, via a vehicle like the EWJ ETF, rather than currency-hedged positions.

Thailand has a strong currency, high current account surplus, low inflation, high real GDP growth, a high savings rate, and a new government plan consisting of investments in infrastructure, research and development, and education. I think the “Thailand 4.0” plan is about the smartest government plan for growth I have ever seen. Though the investment community remains relatively skeptical about the Thai government’s ability to pull this off, and indeed about the stability of Thai politics, I think the economic growth ought to empower officials to continue to execute on their plans. At a 40% debt-to-GDP and 2% government bond rates, the government can easily run a deficit to finance its growth plans. The BOT also has ample room to loosen policy. If they BOJ doesn’t loosen, the current account surplus will drive the currency higher. If they do, the loose policy will drive equities higher. Either way, investing in a fund like the THD ETF, which owns Thai stocks in Thai currency, ought to be a winner for 2018. One risk would be the negative demographics of an aging population, which signals weak consumption, however the economy is heavily geared towards exports, which benefit from “synchronized global growth”. Another risk would be the heavy reliance on the auto industry. However, exports to China have actually outstripped exports to the U.S., and the auto industry in China looks much healthier than that of the U.S.

A weak dollar is generally positive for Southeast Asian countries. Many of these countries never really recovered after the currencies were smashed in the late 1990’s. Thailand and Taiwan are breaking out for the first time in two decades, and Japan is breaking out for the first time in three decades. If the prospects for the dollar remain weak, I’d imagine the rally will continue.

One Belt, One Road ought to create a massive boom in Southeast Asia. As far as I can understand, China will build out the infrastructure for the region, and leave the countries with large liabilities to China, denominated in yuan. While it saddles the countries with debt, these countries have underinvested in infrastructure for years, mainly because of lack of capital. The years of underinvestment mean that the initial infrastructure investments ought to have outsized returns for the real economy. The resulting boom in growth will make the countries more able to pay down their liabilities. The growth in foreign assets ought to help balance the large debt loads in China. The infrastructure buildout should create an export market for the previously-troubled Chinese steelmakers. And, eventually, as these countries develop a middle class, China creates an export market for its consumer goods as well.

This should relieve pressure on the Chinese exporting companies, and, in turn, relieve pressure on the Chinese currency. It should also smooth the transition from an export-led economy to a consumer-led economy. In addition to directly investing in Southeast Asian countries, investing in Chinese consumer names may be an interesting play. I am invested in JD, Tencent, and considering plays in Ctrip or other companies levered to Chinese tourism, both because of the massive growth in the individual companies, and potential for continued growth from the rise of consumerism in China.

I’d expect OBOR to create a boom-bust process in Southeast Asia similar to the 1990’s wave of investment, but on a much larger scale. Eventually, the liabilities will grow too large, and growth will not be sufficient to repay the liabilities. At that point the process will reverse. China will be left in a precarious position of either devaluing its currency to bail out the Southeast Asian countries, which would harm the domestic consumer, or letting Southeast Asia crater. I’d imagine it would elect to do the former. I think we are years away from such a turning point.

I am on the sidelines with regards to India. Investing in the SCIF ETF was one of my most profitable trades in 2017. I viewed demonetization as a net positive, because it would take cash out from under mattresses and inject it into the banking system, creating an extraordinary amount of new liquidity. However, most market participants viewed it as a negative as it disrupted consumer spending in the short term. I sized the position very large after the fall from the demonetization scare, and I was well rewarded. I think the valuations have run considerably and India will need a “catch-up period” for earnings to grow into implied valuations. Modi has announced a plan to recapitalize the banks to deal with the problem of large non-performing loans, but I am wary that this is similar to China’s propping up of “zombie companies” after the collapse in metal companies in 2011.

One interesting theme I will watch is Indian defense. India cannot stand idly by as China makes alliances on all sides, and it does not want to play ball and become a Chinese subsidiary with One Belt, One Road. I’d imagine they have quite a bit of posturing to do to reassert themselves against China’s growing shadow over the region.

Pakistan is looking attractive as it has sold off quite hard after a corruption probe into the former Prime Minister. The key question will be whether this leads to further political instability. I think 2018 might start bringing some benefits from the China Pakistan Economic Corridor, and some of the initial infrastructure gets completed. Moreover, Pakistan’s economy tends to follow India’s economy with a slight lag. I haven’t invested yet, but I am monitoring the situation closely, and may pick up shares in the Pakistan ETF.

In South America, I have been monitoring Argentina closely. Victories for Macri’s party in October mean he now has a mandate to implement reforms. From my conversations with locals, companies are receiving bids from foreign investors for the first time in years. This opening up of markets to foreign capital ought to create a boom in the economy. However, the stock market is still relatively small compared to the rest of the economy – around 9-10% of GDP. Very few firms are actually listed, which means international investors looking to get a piece of the turnaround are pushing valuations to very high levels. I am still bullish on the market, but I am wary that the boom can peter out as more and more companies list and valuations come back to earth.

Cannabis is an interesting area to watch in 2018. I have been investing throughout the rally in 2017, but I sold all my holdings on December 30th as all the stocks swooned in the afternoon. The fact that the stocks have recovered most of the losses after Jeff Sessions’ scare tactics shows me that the rally still has strength. I’ll look to get back in as I believe the rally should continue until Canada goes legal for recreational purposes in June 2018. After that, I have no insight as to where the companies will trade. It is interesting to me that the stocks have made such dramatic moves, and the companies have raised billions, with almost entirely retail investor involvement. Large institutional investors have stayed on the sidelines, but I think they will get involved in 2018, and this should push valuations even higher. I don’t think the boom will end soon.

I think the best approach would be to invest across the spectrum, with some capital going to large companies likely to be institutional favorites, like Canopy Growth, and some capital to small companies with some positive economics, like Cronos Group, for example. Valuations are very stretched, but prices have become dislocated from fundamentals. Eventually valuations will matter, and we will get a large correction in the stocks, at which point only the “real” companies will survive. I think private market valuations are much more attractive right now across the space, and I would look there to achieve less speculative long-term returns.

Despite a positive outlook for commodities, I would not be involved in gold at the current time, because of the continued run in cryptocurrencies. They could take significant market share from gold as a store of long term value. Gold is approximately a $10 trillion asset class, so with significant penetration it is conceivable cryptocurrencies can become a trillion-dollar asset class. With a world economy of approximately $80 trillion, gold currently sits at 12.5% of the global economy, but at times, the size of the gold asset class has gotten significantly bigger. It is conceivable that any additional gains for the “store of value” asset class go to new cryptocurrencies instead of gold. However, the rapid rise in cryptocurrencies, the substantial volatility, and the involvement of insiders who understand the market much better than most retail traders, makes for a dangerous market to play in, especially if you don’t know what you’re doing (and I’ll freely admit I don’t). The only insight I can derive from the matter is that I would not invest in gold at the current time, and I believe the market price of gold could have significant downside if cryptocurrencies continue to gain in value.

If you want a hedge against inflation, it makes more sense to me to invest in real estate. As I am mostly concentrated on liquid financial markets, I have been searching for good stock ideas where real estate held might be worth considerably more than the market capitalization. A couple of small examples might be Maui Land and Pineapple, which holds vast tracts of Hawaiian real estate, and Amrep, which holds huge tracts of land in New Mexico.